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I am a theoretical physicist and currently Director of UCITE (University Center for Innovation in Teaching and Education) at Case Western Reserve University in Cleveland, Ohio. I am the author of three books: God vs. Darwin: The War Between Evolution and Creationism in the Classroom (2009), The Achievement Gap in US education: Canaries in the Mine (2005), and Quest for Truth: Scientific Progress and Religious Beliefs (2000). Disclaimer: The views expressed in this blog are my personal ones and are not those of UCITE or Case Western Reserve University. If you wish, you can send me an email by clicking here.

April 08, 2009

Financial frauds-1: Introducing Charles Ponzi

Recently there have been two major fraud scandals in the US, one perpetrated by Bernard Madoff and the other by Allen Stanford, both based on so-called 'Ponzi' schemes. These exploded on the financial world as big surprises. But there was a similar huge scandal that took place in 2006 but since its impact was felt mostly in Spain, the media here did not give it much publicity, though doing so might have alerted people earlier as to what Madoff and Stanford were up to. Economist Michael Hudson gives the background on the Spanish fraud.

The Spanish scheme involved the trading of rare stamps by a Spanish holding company called Afinsa that bought up a New Jersey stamp auction firm and combined it with a Spanish auction firm to create Escala, the third largest auction firm in the world, after the much better known Sotheby's and Christie's. Their business model was to buy and sell rare stamps for dealers and collectors, making money on safeguarding and curating the stamps while also making profits on the transactions. Since the prices of rare stamps seemed to be always going up, they were able to promise and deliver to investors steady rates of return of 6% to 10%, higher than government bonds and much of the rest of the market, and thus convince investors to put money into the company.

But in May 2006, Spanish police raided the firm and on examining the books, found that the stamps they purportedly had either did not exist or were of much lower value than claimed. The firm was accused of running a pyramid or 'Ponzi' scheme.

So exactly what is a Ponzi scheme? Hudson recapitulates the original scheme by Charles Ponzi that has inspired a particular kind of fraud that will be forever associated with his name.

Charles Ponzi was a poor Italian immigrant who arrived in the US in 1903. His stated business model was based on what is called 'arbitrage'. This is where a person takes advantage of a difference in the price of something in two different markets separated by either space or time, so that if one buys in one market and sells quickly in another market for the higher price, then one makes a profit, often without the nuisance of even having to take possession of the item being bought and sold. (True arbitrage, where the buying and selling is done simultaneously in two different places, is only possible in modern times and with deals that can be transacted electronically, such as securities and currencies and other similar financial products.)

People do this with foreign currency trading if they can predict which way the value of a currency will go. Suppose that at some time a US dollar and a British pound are at parity, meaning that they have equal value. You could buy a dollar with one pound and if the pound later depreciates so that it now trades at two pounds to one dollar, then the dollar that your original pound bought can now be used to buy back two pounds, giving you a 100% profit.

The financier George Soros is supposed to have hugely increased his fortune by betting that the value of the British pound would go down. He sold so many pounds for other currencies that the market was actually influenced by his actions, with other traders thinking that he was betting on something that would actually happen and they also started selling their pounds, causing a run on the currency and driving down its price, and creating a self-fulfilling prophecy.

The catch with this kind of trading is that the differences in trading values in the two markets are usually very small, especially over short time periods and, because of fees and other costs, ordinary people cannot make money from it. One has to be a trader oneself and thus avoid the commissions or have a lot of money to invest in order to make money. But a hundred years ago in Ponzi's time, there existed something called postal coupons that enabled an investor to make money on what seemed like a sure thing.

Postal coupons are no more (I think) but they were common when I was a student and were essential back in the days when buying and selling foreign currencies was not easy or if you lived, like me, in a country that did not allow you to convert your local currency into foreign ones.

The problem the coupons solved was this. Suppose that you needed someone in another country to mail something to you but you had to pay the cost of postage. One way was to send money to the recipient to cover the cost of stamps. But this meant that either you or the recipient had to convert your local currency into the foreign one, which could be a nuisance or even, as it was in my case in Sri Lanka, impossible except in the black market.

Postal coupons were created to solve this problem. You could legally buy such coupons in your own country in your own currency but in the denomination of the foreign currency to cover the cost of stamps in the other country, and then mail the coupons. The recipient could exchange the coupons in their post office for stamps and mail your package to you.

What Ponzi did was take advantage of the fact that the exchange rate at which postal coupons were valued badly lagged behind the exchange rates of currencies, enabling him to take advantage of the difference.

Next: How Ponzi's original scheme worked.

POST SCRIPT: Why not calculate the budget on an abacus?

Why is it that members of Congress, during their debates, still prepare large posterboard charts that are then mounted on hard backing and placed on easels? Do they think they are still in middle school? Haven't they heard that there are things called computers? Projection systems? PowerPoint? Is there some arcane rule that says that Congressional aides must waste their time producing huge charts that might have just one word or one number? The members of Congress using this seem to think that this produces some kind of dramatic effect when all that it indicates is the sense that the speaker is out of touch.